Buying the Last Cheap Asset Class Is a Dangerous Game

In a market where everything from U.S. equities to real estate investment trusts to junk bonds looks pricey, there may be one last remaining cheap asset class: volatility.

Market volatility is at its lowest levels since (gulp) 2007. Add in the fact that the S&P 500 itself is 30 percent above where it was in 2007 and it’s no wonder many market-watchers expect more volatility. "It will take a lot of good luck to keep volatility as low as it currently is," wrote BlackRock Chief Investment Strategist Russ Koesterich in a recent blog post .

But for the average investor, actually betting on what seems like a sure thing is messy at best , and dangerous at worst.

The Chicago Board Options Exchange Volatility Index, known as the VIX or "fear index," is the standard measure. You can't buy a VIX Index ETF the way you can buy the Vanguard Total Stock Index ETF, though. It's more of a theoretical measure, tracking volatility as implied by the price of options to buy or sell the S&P 500. The best investors can do is invest in futures on the Index.

There are a slew of exchange-traded products that serve up this exposure. The most popular is the iPath S&P 500 VIX Short-Term Futures Exchange-Traded Note (VXX ). It trades more than Oracle Corp. every day and does a great job of tracking VIX short-term futures.

Watching for Bubbles

That's the good news. The bad news: VIX short-term futures do a poor job of tracking the VIX Index. That's due to crippling costs from managing futures contracts as they roll from one month to the next. This essentially hamstrings every single VIX-tracking ETF or exchange-traded note.

Just how bad are the costs? Put it this way: The VIX index is down 64 percent over the past five years; VXX is down 99 percent. In the past 12 months the VIX was down 36 percent, while VXX fell 66 percent. Or, how about in January, when the fear index spiked up 34 percent? VXX was up just half that amount. In short, VXX serves up the worst of both worlds.

So what can an investor do to hedge a portfolio against volatility? The answer is simple, and it works. Diversify your risks.

Something as boring and simple as a long-term Treasury bond ETF can help hedge a portfolio in a crisis. In January, the last time the VIX jumped, the market was down 3.5 percent and the iShares 20+ Year Treasury Bond ETF (TLT ) was up 6 percent. Or how about 2008, when the VIX spiked, the market fell 36 percent and TLT rose 33 percent? While long-term Treasury bonds are sensitive to any rise in rates, that won’t be an issue if the market's tanking and volatility's rising.

TLT is just one example of the myriad ways to balance a portfolio, offset equity positions and prepare for a spike in volatility. Granted, it's hardly as sexy as trying to play the VIX Index. But sometimes boring is better.

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Eric Balchunas is an exchange-traded-fund analyst at Bloomberg. More ETF data is available here, and weekly ETF podcasts can be found here.

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